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Few claims result in judgments as long as that recently handed down by Mr Justice Males (the Judge) in the litigation between UBS, Kommunale Wasserwerke Leipzig GmbH (KWL), Depfa Bank plc and Landesbank Baden-Württemberg (LBBW), but the length of the judgment is proportionate to the complexity of the issues decided by the Judge in the four actions between the parties (all of which were tried together).

This update considers only one of those issues, of particular significance for Depfa, for which this firm acted in the litigation. That issue was whether, in inviting Depfa to intermediate in a swap between it and KWL, UBS made certain implied representations to Depfa in relation to its belief in the honesty of those acting for and advising KWL, and the integrity of the transaction proposed.

The Judge held that UBS had indeed made such representations, which it knew to be false, and that it was liable for fraudulent misrepresentation as a result.

This decision should be noted in particular by banks, but its implications extend beyond the banking sector. While the facts of this case are unusual, and on occasion distinctly unsavoury as regards the conduct of individuals employed both by UBS and KWL, the principle articulated by the Judge in this aspect of his decision is likely to resonate in other scenarios.

Summary of the factual background

UBS needs no introduction. This litigation involved both its investment banking business, which was party to various of the disputed transactions, and its asset management business (accused successfully of negligent management of various CDO portfolios).

KWL is a private company incorporated in Germany. It is responsible for the provision of water and wastewater services (and various ancillary services) in the Leipzig area. All its decisions relevant to the litigation were taken by one of its managing directors, Mr Heininger. KWL was (at least notionally) advised in relation to the transactions which were the subject of the dispute, by a Swiss entity called “Value Partners”, specifically by two of its representatives, Messrs Senf and Blatz.

Some years before the relevant transactions took place, KWL entered into various cross-border leasing (or CBL) arrangements in relation to its assets in order to reduce its tax liabilities. It leased those assets out on a long-term basis and leased them back on a short-term basis and was paid a premium for doing so. However, it needed a large sum to be able to re-acquire its assets at the end of the CBL arrangements.

In order to obtain this sum, KWL entered into long-term payment agreements with various financial institutions (referred to in the litigation as Balaba, GECC, MBIA and Merrill Lynch). The exact mechanics of these agreements are not relevant for present purposes, but they involved KWL receiving long-term notes from each entity. That meant that if the institution defaulted, KWL would not receive the money it needed in order to re-acquire its assets.

KWL (at the instigation of Value Partners) started discussions with UBS in early 2006 about restructuring its exposure to Balaba, GECC, MBIA and Merrill Lynch. The scheme which was agreed was broadly as follows. KWL bought credit protection from UBS in relation to a default by the institutions. In exchange, it sold credit protection to UBS in relation to the potential default of a synthetic portfolio of assets. It is the latter part of the arrangement which is now the subject of the dispute.

The intention was for KWL to enter into a Credit Default Swap (or CDS) with UBS. Under the CDS, KWL would receive a premium in exchange for selling UBS protection in relation to the default of a Single Tranche Collateralised Debt Obligation, or STCDO.

While the aim of the transaction stated to UBS's credit approval team, to Depfa and to others was to diversify KWL's risk away from the four financial institutions to which it was exposed, to a broader risk base represented by the STCDO, the Judge found that KWL's actual aim, known to Value Partners and at least some members of the deal team within UBS, was to achieve a substantial upfront premium on the sale of the STCDO protection to UBS. In the event, that premium (worth some US$29 million in total) was for the most part appropriated by Value Partners, which then paid part of it to Mr Heininger. It was not suggested that anyone at UBS knew this, although (as will be explained further below) UBS was held to know that Value Partners and Mr Heininger were dishonest.

The effect of the proposed transactions between UBS and KWL was that UBS faced a significant credit exposure in relation to KWL. It was also the case, as became clear from UBS's disclosure and evidence at trial, that its credit approval team refused to give permission for the transaction as envisaged to proceed, the stated reasons being that the potential credit exposure was too large for KWL, and that the reputational damage to UBS if the transaction were to go wrong was too significant, given both KWL's relative lack of sophistication and the profit UBS made on the deal (in excess of US$20 million).

UBS's senior management was drafted in to force the deal to go ahead over the heads of the credit approval team, which maintained its objections. However, in part concession to those objections, it was decided to split the STCDO arrangement into three parts, and involve two other banks in order to spread the risk of the arrangement. Those other banks were Depfa and LBBW, both of which were invited to participate on the basis that UBS had no more credit lines available to KWL.

The end result was that UBS sold KWL credit protection in relation to Balaba, GECC, MBIA and Merrill Lynch. KWL sold credit protection to each of UBS, LBBW and Depfa in relation to the STCDOs. The swaps between KWL and LBBW/Depfa were referred to in the litigation as the "front swaps". Each of Depfa and LBBW entered into a "back swap" by which it sold on to UBS the protection it had purchased from KWL on identical terms, save that each was paid a fee for playing this intermediary role in what was, commercially, a transaction between UBS and KWL.

In part because of poor decision-making by the portfolio manager, the STCDOs on which KWL had sold protection came to have some concentration on financial institutions. When such institutions began to fail during the financial crisis, KWL's payment obligations to the three banks were triggered, and it faced catastrophic losses as a result, running into hundreds of millions of dollars.

The litigation

A maelstrom of litigation ensued, including criminal proceedings in relation to the wrongdoing of Mr Heininger and Value Partners.

Each of UBS, Depfa and LBBW demanded payment of the sums contractually due from KWL, which KWL refused to pay.

KWL's arguments (and the Judge's conclusions) were, in very brief summary, as follows.

That its directors lacked authority (as a matter of German law) to enter into the transactions. KWL failed to establish this at trial.

That KWL's participation in the transactions was procured by Value Partners' bribery of Mr Heininger, and that Value Partners had acted as UBS's agent in doing so, notwithstanding that UBS did not actually know of the bribe. KWL succeeded in this argument at trial in relation to the STCDO it concluded with UBS directly, although it failed to persuade the Judge of its further argument that UBS had in turn acted as Depfa's agent in the transaction, and that liability for the bribe should therefore also be attributed to Depfa.

That it had validly rescinded its STCDO with UBS on the grounds that UBS had caused or known of a situation whereby it did not receive disinterested advice from its agent, Value Partners. It succeeded in this claim as well.

That UBS had misrepresented to it various characteristics of the transactions (on which KWL failed).

That UBS was liable to indemnify it, or pay it damages, in the event that KWL was obliged to make payment to Depfa and/or LBBW under the front swaps (on which KWL succeeded).

UBS in turn argued unsuccessfully that it was entitled to damages from KWL for breach of various warranties given in the contractual documents. KWL was held to have rescinded its direct transactions with UBS, subject to an obligation to make restitution of various sums it had received.

The implied representation about honesty

All of these issues merit individual attention, but it is a separate point to which this article is directed. The background to that point is as follows. UBS's discussions with Value Partners were led (and indeed firmly pushed) by one of its employees, Steven Bracy, who was a friend and former colleague of Messrs Senf and Blatz. It was Mr Bracy who promoted a close relationship between UBS and Value Partners which the Judge held to have the legal effect of an agency relationship: in effect, Value Partners agreed to push "captive" clients who would not question its judgment towards UBS, with a view to UBS concluding profitable transactions with them. KWL was one such client, and the Judge held (as stated above) that this relationship between UBS and Value Partners had amounted to a clear conflict of interest on the part of Value Partners, which UBS must have appreciated.

However, Mr Bracy's involvement went further. It emerged from his evidence at trial that shortly before Depfa was approached to intermediate in the transactions, Mr Bracy had been asked by Value Partners to assist in producing fabricated evidence that would assist Mr Heininger in relation to an investigation being conducted in relation to various trips he had purportedly made for business reasons, paid for by the former company of Messrs Senf and Blatz of Value Partners. In essence, Mr Bracy was asked to find someone who would say that Mr Heininger had been attending to legitimate business matters, and Mr Bracy duly went about doing so, including considering the potential need to pay a bribe to anyone willing to do so. The request came to nothing, but the Judge held that Mr Bracy must then have been aware, if he was not before, of the dishonesty of the individuals involved. Others giving evidence on behalf of UBS agreed that had the bank more widely been aware of this, UBS would have severed ties with Value Partners, and would never have proposed to Depfa the transaction which was eventually concluded.

Representations which the Judge agreed were made

Depfa amended its pleaded case, once Mr Bracy's evidence on these matters emerged, to claim rescission of its "back swap" with UBS on the grounds that UBS had fraudulently made certain implied representations which were false.

There was some argument as to how such representations were to be framed, but it was agreed on the facts that UBS had impliedly represented to Depfa that it would have contracted with KWL directly, had it had available credit lines. It was also agreed that the test for establishing an implied representation was set out in Raiffeisen Zentralbank Österreich AG v. Royal Bank of Scotland plc and required the Judge to consider what a reasonable person would infer was being implicitly represented by the representor's words and conduct in their context, and whether in all the circumstances, it was impliedly represented that some state of facts existed which was different from the truth.

The Judge, applying this test, had no difficulty in finding that UBS impliedly represented to Depfa that it believed Mr Heininger and Value Partners to be honest, and did not have any significant doubts as to their honesty. He came to this view saying that no reputable or honest banker would have proposed such a transaction to another bank in which it knew or believed the counterparty to be dishonest, or where it had significant doubts.

The Judge also accepted that UBS had impliedly represented that the transaction proposed to Depfa was not tainted as a result of the bribery of Mr Heininger or the conflict of interest of Value Partners.

Were the representations fraudulent?

The Judge went on to hold that both representations were false, and was then required to consider whether they were also fraudulent. For this purpose, he addressed the question of whether Mr Bracy's knowledge of Value Partners' and Mr Heininger's dishonesty could be attributed to UBS. The Judge accepted UBS's proposition that if this was simply a case of a representative of UBS making a representation to Depfa which he believed to be true, in circumstances where another representative of UBS (who did not know of the representation made to Depfa) was aware of facts which would mean that the representation was false, then UBS would not be held to have any fraudulent state of mind.

However, the Judge did not accept that this was the correct analysis of the facts, having considered four questions:

whether Mr Bracy's knowledge was UBS's knowledge for these purposes (which he held that it was, applying usual principles of attribution);

whether Mr Bracy intended that the implied representations to Depfa should be made and that Depfa should be misled (which the Judge held that he did, because he wanted the transactions to go ahead, which they would not if he told the truth);

whether such intention should also be attributed to UBS (which the Judge held it should, Mr Bracy having been authorised to procure the conclusion of other transactions with Value Partners, with little supervision by others); and

whether on the facts, it was only Mr Bracy who knew that the implied representations were false (the Judge held that it was not, although Mr Bracy's knowledge went further than that of others).

Depfa therefore succeeded in establishing that the back swaps between it and UBS should be rescinded for UBS's fraudulent misrepresentation.

Contractual estoppel

The Judge also considered a further argument by UBS that Depfa was precluded from running an argument of misrepresentation because of the provisions of an entire agreement clause (clause 9(a) of the 1992 ISDA Master Agreement) and a non-reliance clause in the relevant confirmation. That argument was not relevant to the outcome of the case in that the parties agreed that contractual estoppel could not prevent Depfa from advancing a case in fraud, but the Judge's conclusions are interesting nonetheless.

In particular, the Judge concluded that clause 9(a) of the Master Agreement "is not concerned to exclude liability for misrepresentations at all." He held that the clause is there in order to deal with what the parties have agreed. It is not there in order to preclude reliance on inaccurate statements made by one party to another.

The Judge also held that the non-reliance clause relied on by UBS related solely to representations which were said to amount to investment advice or recommendations of the transaction. This was not the case here.

Implications of the decision on implied representations

As stated above, the facts of this case are unusual, but that does not mean that this aspect of the Judge's decision will be confined to a narrow body of cases.

In essence, it must mean that where Party A invites Party B to enter into a transaction with Party C, it is very likely that A will be held as a matter of course to represent to B that it has no significant doubts as to C's honesty, or specific reason to be concerned about the transaction proposed.

Such tripartite relationships are fairly commonplace in a number of scenarios. Intermediation in derivatives transactions is but one example. The making of such implied representations is not unreasonable. Where it is likely to expose banks (and indeed other large organisations) is in situations where there is a "bad apple" within the organisation who knows such a representation to be false. That said, UBS did not help itself in terms of the Judge's conclusions on attribution of knowledge. The Judge noted that Mr Bracy had been encouraged to pursue an inappropriate relationship with Value Partners with very little oversight.

It could be said that the decision in this case risks imposing a duty to warn a counterparty of one's suspicions, but this would overstretch the Judge's findings. He did not find that there was any duty on the part of UBS to warn Depfa, it simply should not have proposed involving it. The position might, hypothetically, be different if UBS had learnt of Value Partners'/Mr Heininger's dishonesty once the transaction was already under discussion. The court's view of what UBS should then have done would be interesting, but that is not a question for this case.

It remains to be seen where future cases will take this principle. One active hive of claims relating to implied representations in banking transactions is of course the world of LIBOR-related litigation, and it will be interesting to see whether the Judge's analysis of a bank's liability for one individual's wrongdoing (or that of very few individuals) on this occasion is prayed in aid of any such claims in the future.